Global Value

February 19, 2013


Over 70 years ago, Benjamin Graham and David Dodd proposed valuing securities with earnings smoothed across multiple years. Robert Shiller popularized this method with his version of the cyclically adjusted price-to-earnings ratio (CAPE) in the late 1990s, and issued a timely warning of poor stock returns to follow in the coming years. We apply this valuation metric across approximately 40 foreign markets and find it both practical and useful. Indeed, we witness even more examples of bubbles and busts abroad than in the United States. We then create a trading system to build global stock portfolios based on valuation, and find significant outperformance by selecting markets based on relative and absolute valuation.

The Futility Of Forecasting
Investors spend an inordinate amount of time and effort forecasting stock market direction, often with very little success. The conventional efficient market theory is that markets are not predictable and cannot be forecasted. Value has no place in the efficient market ivory tower, but does it seem reasonable for an investor, or perhaps a retiree, to have allocated the same amount of a portfolio to stocks in December 1999 that they did in 1982? Of course not.

However, valuation is best used as a strategic guide rather than as a short-term timing tool. It is most useful on a time scale of years and decades rather than weeks and months (or even days). While we can formulate a hypothesis for where the S&P 500 “should” be trading, the animal spirits contained in the marketplace invariably cause prices to deviate quite substantially from “reasonable” levels, often for years and even decades.

There are numerous models to consider when valuing stock markets, and a great summary can be found in a publication by The Leuthold Group titled “Stock Market Valuation: What Works and What Doesn’t?” The paper covers a number of models, including price-to-earnings (P/E) on trailing 12-month earnings per share (EPS), P/E on five-year normalized EPS, return on equity (ROE)-based normalized EPS, dividend yield, price-to-book, price-to-cash flow and price-to-sales. In general, they find that many of these metrics are decent at forecasting stock returns. Other models include the Q-ratio, and market capitalization to GNP/GDP (Buffett’s favorite). Another great summary is set forth in the paper “Estimating Future Stock Market Returns” by Adam Butler and Mike Philbrick.

However, we are not going to summarize all of the stock valuation models in existence; rather, we will focus on just one.



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